Understanding trade credit advantages and disadvantages is crucial to helping you decide whether you should offer trade credit to customers or use trade credit when buying supplies for your business.
Trade credit can be a lifeline for business cash flow, but there are plenty of trade credit pitfalls to know about.
What is trade credit?
Trade credit opens in new window is where one business provides a line of credit to another business for buying goods and services.
For example, a garden landscaping business might use trade credit to buy materials for a landscaping project, buying on credit and promising to pay within a set term – often 30 days.
As a business, you can offer trade credit to other companies and also use trade credit facilities offered by other companies.
Trade credit is less formal than a loan from a bank opens in new window, though there are usually terms and conditions attached, including penalties and interest for late payments.
Trade credit is a mutually beneficial arrangement – customers are able to buy goods on credit, and suppliers opens in new window can attract more customers by not demanding cash up front opens in new window.
Trade credit advantages and disadvantages are different depending on whether your business is the buyer in the agreement and using trade credit, or a supplier of trade credit.
Before accepting trade credit, it’s best to know the positives and negatives of any agreement.
Starting a business doesn’t come with a set of instructions.
We know that understanding the many different types of financial product in the marketplace can be difficult.
Our Making business finance work for you guide is designed to help you make an informed choice about accessing the right type of finance for you and your business.
Advantages of trade credit for buyers
While there are some trade credit disadvantages for buyers, there are more advantages for businesses looking to use trade credit to buy goods, materials and services without having to pay up front or on delivery.
Benefits range from accessibility and cash flow advantages opens in new window to helping new startup businesses get off the ground.
Help start-up businesses get up-and-running
Trade credit can be useful for new businesses unable to raise funding or secure business loans opens in new window, yet need stock quickly.
However small businesses can be hamstrung by a lack of trading history which makes obtaining trade credit difficult opens in new window.
Get a competitive edge
Buying goods as required on credit gives businesses a competitive advantage opens in new window over rival firms that may have to pay upfront.
Using trade credit allows your business to be more flexible, adapting to market demands and seasonal variations opens in new window so that you have a constant supply of goods despite any fluctuations in your finances.
No cash required upfront
With no need to pay cash up front, buyers can stock up in time for peak demand opens in new window, such as placing bigger orders to take advantage of key seasonal selling times such as Christmas.
Trade credit is an advantage as cash flow may be low coming off quieter months, which might otherwise prevent enough stock to be purchased for peak selling times.
Fuels business growth
Think of trade credit as an interest-free loan.
It’s one of the best ways to keep cash in your business, effectively providing access to working capital opens in new window at no cost.
There’s less administration compared to arranging a short-term loan opens in new window.
Easy to arrange
If your business has a good credit history opens in new window, is able to meet a supplier’s requirements and has the ability to make regular payments then trade credit agreements are typically easy to arrange and maintain.
There are usually few formal arrangements or negotiations to complete, making it quick-&-easy to use.
Increases your business’s reputation
Demonstrating your business can make regular payments against credit is a good way of establishing and maintaining it as a valuable customer.
A good trade credit history can mean suppliers treat you as a preferred buyer opens in new window.
Discounts and bulk buying
Suppliers may offer appealing discounts to trade credit customers who pay early, making it a useful way to obtain a discount.
Businesses with a good trade credit history may be offered discounts, especially for bulk purchases, or exclusive access to goods and services.
Advantages of trade credit for sellers
For suppliers, trade credit is all about winning new customers opens in new window, increasing sales and retaining customer loyalty.
Winning new buyers
Buyers like trade credit.
It’s an easy way to ease cash flow, which can help improve a small business’s profitability.
As a supplier, offering trade credit is a useful tactic to win new customers – especially if competitors insist on payment upfront.
Sell more goods and services
Suppliers can mix trade credit with bulk discounting to encourage buyers to spend more.
If buyers quickly sell out of stock, they are more likely to return and buy additional stock to meet customer demand opens in new window.
Improve buyer loyalty
Supplier trade credit can prevent buyers from looking elsewhere and strengthens the supplier-buyer relationship.
Trade credit relies on trust between the two parties, good communication, and a mutually-beneficial relationship that can reinforce loyalty.
Disadvantages of trade credit for buyers
While there are fewer downsides, in terms of trade credit, for buyers than suppliers, there are still potential drawbacks that are worth understanding.
Access to free credit can seem like a lifeline for a cash-strapped business but if the fundamentals of your business opens in new window mean you’re likely to miss repayments, you might want to think again about relying on trade credit.
Hard to obtain for startups
Trade credit seems perfect for startups.
Access to stock without upfront payment could help get your business up-and-running.
However, trade credit is significantly harder for new businesses to obtain or it may be offered on restrictive repayment terms.
Until your business has established itself and built up a consistent trading history, some suppliers will be reluctant to offer your business trade credit.
Penalties and interest
While trade credit is effectively ‘free money’ and can be repaid without interest, missing repayment deadlines can turn ‘free money’ into ‘expensive debt’.
Most trade credit terms and conditions include penalties for late payments and interest payable on outstanding credit.
This can quickly spiral into significant costs if your business doesn’t work to clear trade credit debts.
Fall behind on trade credit payments and your business could face legal action, which could culminate in a court judgment, which will impact your credit rating.
If the judgment debt is not paid, this could result in enforcement action which may include goods and assets being seized to pay outstanding bills or even insolvency proceedings.
Some trade credit terms and conditions include what is known as a “retention of title” clause, which could enable the supplier to take back all goods it has supplied if any payment is missed.
Negative impact on credit rating
Prompt repayment of credit is good for your business’s credit rating; missed deadlines and late payments can quickly harm your rating.
That can have an impact when your business later seeks to raise finance such as obtaining a small business loan opens in new window, as a poor credit rating can affect the amount of interest you’ll have to pay or even if you can secure a loan in the first place.
Loss of suppliers
When faced with a poor-paying buyer, suppliers may be tempted to cut their losses and refuse to work with your business.
Suppliers can pull the plug on working with you, leaving your business unable to operate or meet customer demand – potentially resulting in the closure of your business.
Disadvantages of trade credit for suppliers
The bad news for suppliers is they tend to carry a larger part of the risk in the trade credit advantages and disadvantages equation.
While there are lots of routes open to deal with problem buyers and getting back money your business is owed, these can be time-consuming and costly – potentially impacting your cash flow and causing financial problems.
They are also not guaranteed to result in full repayment (for example, if the buyer has become insolvent).
Buyers paying late is the major problem suppliers face when offering trade credit.
Depending on your industry, be prepared that most buyers will sometimes pay late.
Cash flow problems
Late payments or buyers simply not paying at all can lead to serious cash flow problems for suppliers.
With the need to pay their own outstanding bills, suppliers can be effectively caught between demands from creditors for payment and chasing after buyers for overdue cash.
Ensure your business has a strong cash reserve and doesn’t overextend on credit.
Offering discounts to buyers who make early repayments can also help alleviate cash flow problems caused by late payers.
Late payments are one thing, but non-payment can present a serious challenge.
Customers using trade credit may go out of business or payment may simply be too difficult to chase down, which means your business will need to write off the loss as a bad debt.
It’s worth investigating trade credit insurance opens in new window, which can insure your business for bad debt caused by defaults on trade credit agreements.
Offering trade credit is an act of trust.
Assessing whether a customer has the means to repay you is worth doing right, but determining a buyer’s credit worthiness can be time-consuming.
You’ll need to check references, obtain credit reports and review trading history – all of which takes time.
Offering trade credit involves a lot of paperwork and administration.
As a supplier, you should consider getting professional legal help opens in new window to write terms and conditions, and you’ll need dedicated account handlers to ensure that outstanding invoices are chased up.
Setting clear invoice terms and ensuring good communication can help encourage buyers to pay promptly and regularly.
You may want to investigate online accounts software opens in new window with CRM and invoicing – they often include free alerts when invoices are due.
Thinking of starting a business? Check out our free online courses in partnership with the Open University on being an entrepreneur.
Our free Learn with Start Up Loans courses opens in new window include:
- Entrepreneurship – from ideas to reality
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